Exchange-Traded Funds
Exchange Traded Funds (ETF’s) are becoming popular investment vehicles for many investors. Most ETF’s are cost effective, broad market funds. We have put together a layman’s explanation of exchange-traded funds along with the different indices that can be tracked and be incorporated into an investor’s portfolio. ETF’s are normally invested in the stock or bond markets and therefore have all of the market risk associated with investing. An owner of an ETF can lose money. These can be risky investments. This paper will include some of the advantages and disadvantages of an ETF. These lists are not exclusive and you should discuss your particular circumstances with your advisor and the ETF prospectus.
The Basics
investment adviser and a fee will be paid while some ETF’s can be bought directly from an exchange.
Advantages
Disadvantages
Even though ETFs have many advantages, they also have several disadvantages. A client must evaluate his investment goals before deciding on the appropriate ETF. An ETF are risky investments and can and have lost money.
The difference in the bid-ask price (which is explained below), may be too great to create ideal profits. Tracking errors can occur in an ETF. Tracking errors arise when not all shares of the index are held in the ETF, which in turn, will not exactly replicate the performance. Some ETF’s do not physically hold the underlying asset, so it does not actually own the stock. It may create an artificial position, like holding a derivative, deriving its value from something else. The ETF must have a Principal that can provide the underlying stock for sale. This is another source for tracking error, but it also means taking a greater risk. When ETFs are harder to track, they are more complicated meaning more costs to the client. An ETF has a three day liquidation period so obtaining the cash from the sale of the security may be delayed longer than a corresponding mutual fund or stock.
Uses
Choosing the Right ETF
When considering making an investment in ETFs, you should carefully analyze your objectives, risks, and expenses. After choosing which asset class you wish to invest in, there are a few things you must look at when researching which ETF is best. First is the expense ratio, which is the percentage of fund assets deducted to cover fees. Lower expense ratio does not necessarily mean best performance but it may have an impact if two like ETF’s are compared. For example, if ETF One and Two are designed to mirror the S&P 500, and ETF One has a half of one percent more in fees, an investor may assume that the performance for ETF One will be less than ETF Two.
The trade commission, the fee paid every time an investor buys or sells an ETF, should be determined. Some brokerage fees are higher than others. Look for the funds that have lower fees or commissions. For those ETF’s traded on the open market, the “bid-ask spread,” which is the difference between the ETF price that an investor is willing to pay and the ask price that the seller is willing to accept should be determined.
Best of Both Worlds
An ETF has some properties of stocks, and some properties of an index based mutual funds. An investor can have the best of both worlds in one investment. Like ownership of stock, ETFs have limit, market and stop-loss orders, which can be ideal for controlling your losses. Stocks can be traded on exchange throughout the day, providing the advantage with portfolio flexibility. ETFs can include a basket of securities designed to track a benchmark like an index mutual fund. They have low expense ratios, some with single digit basis points and are tax efficient, increasing an investor’s net return on the investment. Most ETFs are open-ended investment companies (mutual funds), a type of company that allows investors to pool together assets, with opportunity to purchase or sell shares on request.
Wrap Up
